Japan’s Debt Sustains a Deflationary Depression

By A. Gary Shilling -
Jun 4, 2012

Markets have reacted dramatically to
the Bank of Japan’s recent efforts to stimulate the economy with
loans to high-growth sectors; an expansion of its asset-purchase
program; and a new 1 percent inflation target to combat chronic
deflation.

Japanese stocks, especially of major exporters, soared and
the yen tanked, starting in early February. Yet the spurring
effects of monetary easing on Japanese stocks and the depressing
influence on the yen didn’t last long. Since mid-March, the
currency has resumed its role as a haven from euro-area turmoil.
The “risk off” trade is back in favor. Still, I continue to
believe that fundamental changes are occurring in Japan that
will weaken the yen considerably in future years.

Last year, Japan’s gross government debt was 220 percent of
gross domestic product, according to the International Monetary
Fund, by far the largest ratio of any Group of Seven
country. All governments lend back and forth among official
entities so that their gross debt is bigger than the net debt
held by non-government investors, and Japan does this more than
other developed countries. Still, on a net basis, Japan’s
government-debt-to-GDP ratio is rivaled only by Italy’s and
leaped to 113 percent in 2011 from 11.5 percent in 1991.

Ratings Downgrade

Standard & Poor’s has cut the Japanese government-debt
rating to AA minus and Moody’s Investors Service cut its rating
to Aa3. On May 22, Fitch Ratings reduced Japan’s sovereign
grading to A+ and said the government is taking a “leisurely”
approach to dealing with the nation’s debt. Meanwhile, loans
from Japanese banks have dropped precipitously since the early
1990s. That was partly due to the write-offs of bad real-estate
loans. Even so, the revival of borrowing in recent years has
been minimal.

Japan’s traditionally low unemployment rate jumped from 2
percent in the early 1990s to 4.6 percent in April of this
year. The male labor-force participation rate ceased its post-
World War II decline in the bubble 1980s, though the downward
trend has accelerated again since the early 1990s. The female
participation rate rose from the late 1970s until the early
1990s as many women decided that working and remaining single
were preferable to being confined to the home and rearing
children in a male-dominated culture.

Despite aggressive monetary policy since the early 1990s,
Japan has suffered bouts of deflation. The two decades of
economic stagnation were compounded by the huge earthquake and
devastating tsunami last year. The economic disruptions and loss
of nuclear-power generation remain considerable. Rebuilding will
create jobs and economic activity, but it will simply take
things back to where they were, and at tremendous cost to the
government, insurers and those who lost property, income and
jobs, to say nothing of the thousands of lost lives.

Japan seemed poised to take over the world in the late
1980s at the height of its real-estate and stock-market booms,
but it has undergone a huge reversal. Back then, many Americans
believed they would soon be working for Japanese companies or
would be run out of business by them. Japan’s exports of
vehicles, consumer electronics and other goods achieved global
dominance from standing starts after World War II, and the
Japanese used their export earnings to buy Midwest farmland,
Pebble Beach and Rockefeller Center. Japan remains the world’s
biggest creditor country with net foreign assets of $3.19
trillion.

Wealthy Country

Does all this mean that Japan is finished as a major
economy? Hardly. Despite little growth in GDP per capita since
1995, it is a wealthy country. In 2010, GDP per capita was still
more than that of France, Germany, the U.K. and Italy. And
China’s economy is now larger than Japan’s because of its huge
population, 1.3 billion compared with 128 million, though
China’s $5,414 GDP per capita is only 12 percent of Japan’s
$45,920.

The Japanese are tough and will rebuild their economy in
the aftermath of the earthquake and tsunami. The destruction,
excluding the nuclear ramifications, was initially estimated at
only 4 percent of GDP.

The nation is well-educated and dedicated. The group
decision-making process, called “ringi-sho,” is slow and
laborious, but once the group makes up its collective mind, it
turns to the task at hand with resolution. This dedication in
the face of adversity is summed up by the phrase, “fukutsu no
seishin,” or “never give up.”

That attitude revived a largely destroyed economy after
1945, and made it the envy of the world in the 1980s. The World
War II defeat was a psychological disaster for the Japanese who
previously viewed unconditional surrender and foreign occupation
of their country as unthinkable. In the late 1900s, this
mentality was responsible for the rapid conversion from a
primitive, feudal nation to a modern industrial economy.

This perseverance has driven efforts by the government and
central bank to resurrect the economy for two decades, but with
little success. Instead, these attempts have set up Japan for a
slow-motion train wreck, characterized by leaping interest rates
on government debt and a collapsing yen.

The Bank of Japan helped pop the 1980s housing and stock
bubbles by raising interest rates starting May 31, 1989. After
the bubbles burst, the central bank slashed its reference
overnight rate to zero and has kept it close to that level ever
since. That pumped money into the economy, to no avail. In any
case, even if nominal rates are zero, borrowers are discouraged
by positive real rates in periods of deflation. And zero is
usually as low as central banks can go, though the U.S. Treasury
is considering issuing bills at premiums with the resulting
negative returns. Japan’s financial system remains in the
classic liquidity trap where no interest rate is low enough to
encourage scared borrowers to borrow or reluctant lenders to
lend.

Quantitative Easing

Substantial quantitative easing by the BOJ through
purchases of government bonds didn’t help much, either. Nor did
the 3 percent annual increase in M2 money supply over the last
two decades. And so far, the central bank’s attempts to promote
borrowing haven’t worked: The trend since the mid-1990s has been
to repay loans that weren’t written off. Nevertheless,
competitive quantitative easing by central banks is now the
order of the day, and the BOJ is being outrun. Last year, it
expanded its balance sheet by 11 percent, while the Federal
Reserve’s increased 19 percent, the European Central Bank’s rose
36 percent and the Swiss National Bank’s grew 33 percent.

Government deficits are supposed to stimulate the economy,
yet the composition of Japanese public spending isn’t
particularly helpful. Debt service and social-security payments
-- generally non-stimulative -- are expected to consume 53.5
percent of total outlays for 2012, compared with 54.4 percent
for 2011. In addition, the gap between public spending and
revenue was 9.3 percent of GDP for 2010, the latest data
available, so debt service now accounts for 43 percent of
government revenue, up from about 4 percent in the early 1970s.
More than half of public spending is financed by new debt
issues. As a result, the government borrows heavily just to
service debt.

Japan wants to double the 5 percent sales tax in two stages
by 2015 to help pay for increasing welfare costs as the
population ages. The country’s leaders also want to demonstrate
some control over the deficit and curtail further rating
downgrades. They also want to prevent a sell-off of government
bonds: In late March, foreigners sold more than 2 trillion yen
($25 billion) in Japanese obligations, one of the biggest
outflows since the collapse of Lehman Brothers Holdings Inc. in
September 2008.

But when the government last raised the sales tax to 5
percent in 1997, a recession followed. Furthermore, the military
rise of China in Asia, North Korea’s nuclear ambitions and the
planned reduction of U.S. defense expenditures have increased
pressure on Japan to boost military spending. At $59 billion in
2011, the defense budget was already 5.2 percent of total
government outlays, making it the sixth-largest in the world.

(A. Gary Shilling is president of A. Gary Shilling & Co. and
author of “The Age of Deleveraging: Investment Strategies for a
Decade of Slow Growth and Deflation.” The opinions
expressed are his own. This is the second in a five-part series.
Read Part 1 and Part 3.)